The eurozone has already put virtually impossible demands on member states

It was with evident glee that José Manuel Barroso, head of the European Commission, observed last week – while in Athens to press the starting button on the Greek presidency – that those who had predicted the break-up of the euro had been proved comprehensively wrong.

Not only had the euro survived, but as if this were not a triumphant enough end in itself (for him, it plainly was), the euro area was now “turning the corner” and was “back on the right track”.

For evidence, he cited Ireland, which last week saw investors scrambling for bonds in the first issue of new sovereign debt since exiting the financial assistance programme, and Latvia, which is showing the strongest growth in the European Union and recently became the 18th country to join the single currency.

Few European leaders stir eurosceptic passions quite as strongly as the pontificating Mr Barroso, but let’s give credit where credit is due. We’ll forget sky-high unemployment and collapsed economic output, the euro has indeed survived, and with the immediate financial crisis now in remission, there are even signs of returning growth.

This may be no more than the inventory bounce you would expect once the prospect of break-up is taken off the table, but we’ll see. Admittedly, surveys of business and consumer confidence point to something a little more substantive. Even so, the underlying causes of the crisis – gross capital imbalances – remain largely unaddressed. What is more, as the prospect of currency implosion recedes, a whole new threat is beginning to loom – that of price deflation.

This latest risk may or may not be overblown, but the fact is that core eurozone inflation fell to a record low of 0.7pc in December. With manifest overcapacity in labour markets and beyond, outright price deflation looks uncomfortably close. Germany’s cultural aversion to the scourge of inflation is putting large parts of the eurozone at risk of something very much worse.

Persistent price deflation, or even just very low rates of inflation, will not only cause spending to be deferred, thereby depressing growth, but will also add to the burden of debt repayment.

The eurozone has already put virtually impossible demands on member states by prescribing a government debt target of 60pc, and requiring that one 20th of any excess over this level should be repaid each year. The OECD calculates that to stay within this rule for the next 10 years, Greece will have to maintain a primary budget surplus of 9pc, Italy and Portugal 6pc, and Ireland and Spain 3.5pc.

Even with decent levels of nominal GDP growth, this is an extreme ask; in conditions of price deflation it becomes virtually impossible. Already we are seeing something very close; even nominal GDP has been declining in Italy, a virtually unheard of phenomenon. Yet the eurozone still clings to the pretence that debt sustainability can be achieved through a mixture of austerity, forbearance and structural reform.

This defies not just common sense, but virtually all historical precedent. Most will know the old joke that if you owe the bank £100,000, you’ve got a problem, but if you owe it £100m, it is the bank that has the problem.

European creditors just cannot bring themselves to recognise that they have lost their shirts on the debt boom of the pre-crisis years. By punishing their debtors with harsh medicine, they are only further diminishing the chances of getting their money back.

In a recent working paper for the International Monetary Fund, the economists Carmen Reinhart and Kenneth Rogoff have put the historical evidence through the meat grinder, and they find hardly any cases of countries reaching debt sustainability in the manner prescribed by the eurozone.

Debt restructuring or conversions, financial repression and higher inflation have nearly always been integral to resolution of significant debt overhangs. Denial of this reality in the eurozone is leading to policies that exacerbate the final costs of the deleveraging.

Much the same point is made by Nicholas Crafts, professor of economic history at Warwick University, who observes that “sadly, the euro area is following a trajectory that looks rather too reminiscent of that of the gold-bloc countries in the 1930s”.

None of this is exactly revelatory. Right from the start of the crisis, the choices have been obvious. There are only four ways of reducing excessive public debt – economic growth, fiscal adjustment, default or inflation, the latter of which is sometimes pursued through the “financial repression” of negative real interest rates.

Outright default is actually much more common than you might think, even among advanced economies. It happened a lot in the interwar years. After the First World War, the US was eventually forced to write off debt to foreign countries – mainly European – equating to roughly 15pc of GDP. The US also defaulted on its own debt, by declaring a 40pc reduction in the gold content of US dollars.

Debt restructuring of this sort is nonetheless always a profoundly difficult, protracted and divisive process. Even the limited restructuring achieved with tiny little Greece very nearly failed. Prof Crafts calculates that to go further and forgive, say, a quarter of the debts of Greece, Ireland, Portugal and Spain would cost €1.2 trillion (£1 trillion) – plainly a political and financial non-starter.

Similarly, the degree of austerity required to eliminate the debt overhang would risk social and political revolution. That leaves just growth and inflation, which is essentially the strategy being pursued by the UK government today. It is also the path the UK trod in eliminating high public indebtedness both after leaving the gold standard in 1931 and after the Second World War.

Any concerns the central bank might have over inflation are made subservient to the priority of stimulating nominal GDP growth. External debt is similarly devalued through currency depreciation. The Government is essentially taxing savers and creditors by stealth and hoping they won’t notice, or at least won’t complain too much. It’s unfair, but politically it’s also an easier and less brutal approach than the alternatives.

As Europe’s largest creditor nation, Germany today resists all notion of burden-sharing, yet ironically it has repeatedly dished out such treatment to its own creditors – twice to its citizens through hyperinflation, when their savings were completely wiped out, and twice via post-war restructuring of external debts.

Since the Cypriot debacle, Berlin seems to have decided in its wisdom that although sovereign debt must remain sacrosanct, it’s perfectly all right for bank creditors to take a haircut. Brilliant; the effect is to make it even harder for banks in depressed economies to fund themselves, and thereby restart the engine of credit growth.

One way or another, Europe will eventually have to provide a mechanism for burden-sharing. Whether it is through comprehensive debt mutualisation, break-up of the eurozone, restructuring or simply European Central Bank monetisation is not yet certain. What can be said is that the longer the delay, and the worse the deflationary pressures get in the meantime, the more painful, divisive and recriminatory the eventual solution will be.